Why Are Stocks Volatile When Things Seem to Be Going Well?

The stock market has had another volatile week, adding more twists and turns to the drama that is October. The recent action represents a pretty stark turn. Just a few weeks ago stocks were setting records after a fairly smooth rise through the summer, with both the blue-chip Dow Jones Industrial Average™ and broader S&P 500® Index swaggering into October at historic highs. Now the two indexes are down about 4% for the month so far.

Investors have been looking out for an end to the 10-year bull market for a while now. So is this it?

Not necessarily.

“The bull market may have more legs, and upside surprises are possible, but risks have been rising over the past year or so,” says Liz Ann Sonders, Schwab senior vice president and chief investment strategist. “The recent action in the stock market illustrates once again why it’s important for investors to remain disciplined and diversified in a way consistent with their risk tolerances and investment goals.”

Big picture

The recent market volatility doesn’t seem to jibe with all the good news about the economy out there. After all, growth is solid and the unemployment rate hasn’t been this low in decades. Wages are also finally starting to tick higher, if modestly, after years of just muddling along.

And corporate earnings are still looking good, with a large chunk of the companies that have reported third-quarter results so far beating analysts’ expectations. In fact, a handful of strong earnings announcements on Friday helped the Dow eke out a small gain for the week.

Of course, the stock market prefers to look ahead, and there are already signs that the data may not be as good going forward. In fact, some leading economic indicators, which can signal potential changes in the economy before they show up, are already deteriorating. Auto and home sales, for example, have both been weakening. And analysts are already forecasting a sharp slowdown in earnings growth next year. But that’s not all.

Yields, rates, trade and more

Much of the recent volatility traces back to two things: rising bond yields and concerns about trade.

Bond yields have surged in recent weeks to account for stronger economic growth and the fact that central banks are slowly bringing the curtain down on the post-crisis era of easy money. Why does this spook stock investors? Treasury yields are the baseline rate that is used to value other financial assets. When yields on Treasuries rise, they compete with the returns from other assets. Also, bond yields rise when bond prices fall, and the selloff in bonds could reflect concerns that central banks, including the Federal Reserve, could raise interest rates too fast in their bid to keep the economy from overheating. Rising rates also make borrowing more expensive and slow economic growth.

“As the world’s major central banks tighten their monetary policies, the low-volatility, low-risk world of investing we’ve enjoyed for most of the past decade will give way to a higher-volatility, higher-risk investing world,” says Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. “In other words, the era of easy money is ending, and that means the investment strategies that worked over the past decade are not likely to work as well over the next decade.”

Trade has also been top of mind. While one source of uncertainty was resolved with the renegotiation of the trade agreement between Canada, Mexico and the United States, the tensions between the United States and China remain high. The two sides continue to swap harsh words, new tariffs and other measures, which are already creating problems for U.S. companies that do business in China or rely on imports from there. They could also make goods more expensive for everyday consumers.

Together, tighter monetary conditions and restrictions on trade can help explain some of the decline in home and auto sales mentioned above, as rising interest rates and new tariffs make loans and raw materials more expensive.

Finally, the stock market could be anticipating the end of the sugar high that followed the slashing of the corporate tax rate this year. Companies have been dishing out cash to shareholders in the form of dividends and buybacks this year, which helped push the market higher. S&P reports that through the end of the second quarter, buybacks were up roughly 50% compared to a year earlier and a record for any 12-month period. Meanwhile, dividends for S&P 500 Index companies totaled $111.6 billion in the second quarter—up over 7% from the previous quarter and also a record.

“The rub to this market support is that it will inevitably begin to fade as we move into 2019,” says Liz Ann.

Stay disciplined

While the day-to-day swings in the market are extremely difficult to predict, we have been warning that conditions could grow more volatile this year as we moved into the late stages of the economic cycle. That’s why we have been urging investors to stick with their long-term asset allocations and not to take on any additional risk.

Discipline is warranted: Tighter monetary policy and rising (but still low) recession risk mean diversification and rebalancing will be increasingly important for investors.

So caution is warranted, even if the bull market continues to run.

“As anyone who has had the misfortune of riding out a severe storm knows, the time to prepare is before the event, not during,” says Liz Ann. “Likewise, you should prepare for market corrections while the skies are clear, because storms can come up quickly.”

Revisit your plan and reacquaint yourself with your investment goals and objectives. If you’re not clear about your goals, this would be a good opportunity to craft a plan.

Revisit your risk tolerance. Some investors feel differently about their risk tolerance after they experience volatility firsthand. If you’re not comfortable with your risk level, it may be prudent to reduce the overall risk in your portfolio and think about the right level while taking into account both short- and long-term goals.

Rebalance your portfolio. During periods of volatility, it can make sense to rebalance your portfolio back to its long-term strategic asset allocations. Because U.S. stocks have gained so much in recent years, if you haven’t periodically rebalanced your portfolio—that is, trimmed some positions and added to others to return your portfolio to its target mix—you may be overweight equities and could be exposed to additional risk. Rebalancing regularly can help manage your portfolio risk.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Diversification and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets.

Investing involves risk including loss of principal.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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